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This is intended for entrepreneurs and business owners who are evaluating the possibility of raising a new round of equity from outside investors.
A group of founders who might find themselves in this position are the entrepreneurs who raised capital in the 2020-2022 period. In Latin America alone this group totals around 1,200 startups.
The logic described below applies to these early stage startups, and also to growth companies and more established businesses.
The distinction that I will try to make here is between needing to raise capital and choosing to do it despite not needing it. If you are in the first group you don’t really have a choice. If you are in the second, it’s useful to know it and execute accordingly.
Capitalism is fueled by retained earnings, not equity funding rounds
First some context. The vast majority of growth capital invested within capitalist systems comes from the reinvestment of profits. This is the natural state of things.
Raising new equity to grow a business is the exception. It’s easy to forget this.
The examples below show the way large corporations fund themselves. Retained earnings represent the profits that each company generated throughout its history and reinvested in its own business.
For instance Eli Lilly, a pharmaceutical company with a market value of $850 billion, has funded 97% of its business with retained profits.
The percentages for the 3 large technology companies would be above 99% if we exclude employee stock options from the equation. For instance, Amazon’s shareholders equity is 75% self funded with profits, but of the 25% that comes from “external sources” about 24 percentage points are from stock based compensation, not from issuing equity to investors.
The message is clear: these large companies finance growth with retained earnings, not with new capital from investors.
At the other end of the size spectrum, it’s worth noting that it is possible to create world-changing innovations without much capital. The printing press and antibiotics were both developed with minimal financial resources. Trillions of dollars of value created from essentially no initial investment.
Closer to home, there are many examples of companies that achieved product-market fit without raising equity. I am familiar with several entrepreneurs who have built SaaS businesses with hundreds of clients without raising outside capital.
So when is capital needed?
The decision tree above shows a way to answer this question.
Capital intensity: hardware business and real estate are two good examples. Bootstrapping the next rocket ship company or large chain of shopping malls is not viable. Raising a meaningful amount of new equity capital is almost certainly needed.
Debt financing: if the existing business has enough debt capacity to fund growth without creating dangerous levels of financial leverage, using debt instead of equity could make sense. Equity is not a necessity in those scenarios even for capital intensive businesses.
Winner-take-all markets: some businesses like internet search, social media and marketplaces have these winner-take-all dynamics that demand large upfront investments. Equity is a need, not a choice, to establish many of these businesses.
Founders rapid financial gain: nothing wrong with aiming to create wealth in a short timeframe. The mistake is confusing the main driver of a capital raise. What you are aware of you can control, what you are not aware of is controlling you.
In short, there are some specific situations where raising equity is a real need. For most other instances, it is a choice. Those are two different things. Going into the fundraising battle with this clarity is a big advantage.
Capital as the main competitive tool
A word on capital as a competitive tool. It’s easy to convince ourselves that we need more capital to win. Hire better people, invest more in marketing and so on.
That is a tempting narrative but it usually doesn’t work.
If you take a close look at any successful company, regardless of size, you’ll see that they achieved a competitive advantage through some dimension other than capital. These companies were able to attract capital, or generate it via profits, because of that other dimension.
The flow of causation is not capital => advantage => success, but rather advantage => success => capital.
AI is a good reminder that even for capital intensive businesses -where it makes sense to raise a lot of equity- access to financing is not enough. For example, Meta’s release of its open source Llama models puts a very high floor on what any player in this field needs to offer in order to compete effectively.
The finance sector, where investing capital intelligently is the main job, is another good example. Advantages in this industry are generated by culture and people, not by the size of the balance sheet.
The problem with relying on capital as a competitive tool is that it’s easy to copy. To build a competitive edge you not only need to raise equity, but you also need all of your existing and potential competitors to not have access to similar amounts of capital. What are the chances that your company will be the only one?
In summary
Raising equity capital is only a need in some very specific instances.
For most companies in most situations getting equity from investors is a choice not a need.
Understanding this distinction is critical. It will dictate how much you raise, from what type of investor and under which terms.
If you chose to raise equity despite not needing it, my suggestion is that you write down your rationale, share it with the smartest people you can get to read it, and ask them to give you their honest opinions.
If after this small experiment you remain convinced, you will be able to move forward with clarity and conviction, which is very different from doing it out of inertia or to follow conventional wisdom.
Best of luck!